For beginners, it’s not always immediately clear what an option is, since its value is based on the value of something else. Learn more about terms like “derivative” and “underlying.”
Options are derivative investments, which means their value at any given time is based on the value of something else, known as the underlying instrument. For example, the price of an equity options contract on a specific stock rises and falls as the price of the underlying stock rises and falls, though not necessarily at the same rate.
Options can be valuable additions to your portfolio because, as derivatives, they give you the opportunity to profit from gains and the ability to limit losses in the investment markets at a lower cost than actually buying or selling the underlying instrument.
The underlying instrument that determines the value of an options contract may be an investment, such as stock; a product such as wheat or oil, in the case of an option on a futures contract; or a financial instrument, such as an index. Since the term instrument is the broadest of the three, it's the one most commonly used in combination with underlying, although sometimes 'underlying' is used alone.